WHEN Scotland's biggest financial institution goes cap in hand to investors to ask for £12bn to shore up its balance sheet, there is no escaping the fact that we are facing one of the most challenging periods in modern times.

The question for the country is whether the huge growth in financial services driven by players like the Royal Bank of Scotland (RBS) is now under threat from the worldwide credit crunch.

One pessimistic forecast by the Ernst & Young Scottish Item Club predicts as many as 5000 employees could be laid off by financial services companies over the next two years.

The figures show, when anticipating business for the full year to the end of December this year, 38 per cent feel their prospects would improve while 31 per cent expect to see a decline.

Owen Kelly, chief executive of SFE, is optimistic that the industry can come through the difficult period stronger.

"These results very much reflect the environment in which we are operating," he notes.

"It is quite volatile and some decline in confidence is unsurprising.

However, the diversity of our industry in Scotland and the continuing focus on the long term, for many of our member companies, offer some resilience."

David Claxton, head of the financial services practice in Scotland and Northern Ireland for accountancy firm Deloitte, believes the industry is still in rude health.

"It goes from strength to strength basically because of the quality of people leading the businesses compared to other competing financial services markets," he says.

While the financial services sector in Scotland remains strong - Edinburgh is placed fourth among the top European financial centres in terms of equity assets under management, behind London, Frankfurt and Paris - the country must not rest on its laurels.

There are a number of centres, both in the UK and wider afield, looking to wrestle some of the advantage away from Scotland. UK areas such as Manchester, Leeds and Bristol are seen as competitors while in Europe, Amsterdam, Frankfurt and Paris remain in the frame.

Claxton warns: "The new players are potentially the ones that need to be looked at as well. You now have Poland, Mexico and some of the Asian markets which are also setting themselves up as financial centres.

"They will be offered incentives to attract business there so there is a challenge for the Scottish market to make sure they continue to get the inward investment."

This warning is confirmed in a report out in March from financial services consultancy Accenture, which looked at the position the Scottish financial services industry could find itself in in ten years' time.

The report's author, Trevor Hatton, who is managing director, Scotland for Accenture, argues the country's financial services industry needs to face up to new challenges and start positioning itself for the future if it is to have a chance of continuing to reap the success it has enjoyed up until now.

Casting his gaze forward to 2018, Hatton believes new, regional financial centres around the world will spring up and compete with the traditional axis of London, New York and Tokyo.

"There is a risk financial centres such as Edinburgh will cease to be significant if they fail to keep up with the competition," he adds.

But he feels Scotland is not getting the message out about the benefits for financial services companies being based in the country.

"You only have to look at the recent marketing exercise under-taken by the Swiss cantons - who tried to capitalise on the uncertainty around non-domicile taxation in the UK by tempting foreign workers in the City of London to relocate to tax-friendly Geneva - to understand how much competition there is and will be in the future," he warns.

The problems faced by the financial services industry have led to speculation there could be a massive loss of jobs in the sector. As well as the Scottish Item Club report, the Confederation of British Industry warned that more than 10,000 positions could disappear throughout the UK, in the worst financial conditions seen in nearly 20 years. Those in investment banking and share trading are particularly likely to suffer.

SFE figures show, in Scotland, some 108,000 are currently directly employed in financial services, with a further 100,000 in support services.

Some analysts are expecting Scotland's financial services companies to freeze their recruitment spend during 2008 However, one consultant says feedback from his clients suggests this is not the case and, in many instances, Scottish companies are planning to spend more on a variety of functions, from hiring and HR to risk and compliance, over the next 12 months compared to 2007.

Nicholas Furze, a consultant within the financial services team of executive search consultancy Odgers, Ray and Berndtson, adds: "This is a time of great opportunity for Scotland's financial services community; companies up here should hopefully be a net beneficiary of cost-cutting and possible redundancies in the City.

"Given the growth of financial services in Scotland and London's present economic climate, there will be more Scots willing to return while people without ancestral links are more likely to be open to relocation.

"There is the capacity in Scotland for City-based financial services companies to outsource some of their operations north of the border and it's certainly an easier message to sell to the market and to staff than offshoring to India.

"Many of our financial services clients, from asset managers to retail banking businesses, have told us they would commit to creating new jobs in Scotland for that very purpose."

Sarah McParland, director with recruitment specialists Search Consultancy, is also more upbeat on the Scottish marketplace.

"The recruitment market in Scotland's financial sector continues to be buoyant despite slowing national economic growth and a gloomy global outlook," she explains.

"This is because smaller and midsized firms make up a sizeable portion of the sector and for years have been struggling to compete with larger companies to attract talent as the mechanism of demand and supply of skilled candidates artificially hiked up salaries and remuneration packages.

"Now, with the big companies taking a more cautious approach to recruitment, smaller firms are taking the opportunity to hire the staff they've desperately been after for some time."

While the industry must remain focused on protecting the country's image, how have the main political parties reacted to the importance of financial services to Scotland?

Claxton thinks, in the past, they haven't taken the subject too seriously, but this has changed thanks to SFE.

"SFE has done a good job over the last few years of lobbying the Scottish Executive, making them more aware of the importance of financial services in the Scottish economy," he notes.

"Now, with the Financial Services Advisory Board (FiSAB), there at least is a voice and a connection between government and the financial services industry.

"I'm hearing all the right noises from the political parties but there are some infrastructure things that need to be thought about, like how we can improve transport links. It's important the airport and rail links are looked at and thought through."

While Graham Wood, chief investment officer of equities at Scottish Widows Investment Partnership, believes there is a much better understanding of the part the financial services industry plays in the Scottish economy now than there was ten years ago, he doesn't get the impression that politicians go out of their way to support its growth.

"As long as a wary eye is kept open by governments - both up here and south of the border - on things that could do us a lot of damage, just generally encouraging businesses with efficiency, economic confidence, transport links and good communication links is probably about as much as I would ask," he adds.

SFE's Kelly is also confident that the country's politicians are behind the industry.

"There can't be any doubt the current government, takes it very seriously indeed and representation on FiSAB of the first minister, the cabinet secretary and Jim Mather, the minister for enterprise, is clear evidence of that," he adds.

"It's worth remembering too that FiSAB was set up by the previous administration, so there is a lot of evidence at devolved level that all the major parties recognise the significance of the financial services industry.

"Given that, at the last count, the financial services industry was worth 7 per cent to GDP, contributing £7bn to GDP, and employs more than 100,000 people directly, in many ways it's welcome but perhaps not surprising."

This is a view echoed by Scott McKerracher, regional director for north and central Scotland at Clydesdale Bank.

"We spend a lot of time with the political parties, trying to understand what they are looking for from the banks and also to let them know what we are doing," he says.

"The fact they want to spend the time with us tells us they see it as important and given the large volumes of people that are employed within the financial services industry, this is no great surprise."

Scotland has the opportunity to cement its position as a leading centre of the international financial services industry when the country hosts the first Global Financial Services Week from May 26-30, supported by FiSAB. This is the pioneering collaboration between the financial services industry, unions, the Scottish Government, Scottish Enterprise and Universities Scotland.

Many respected experts in international finance are taking part in a series of events to showcase Scotland's strengths, give firms international opportunities for inward investment and attract talent to the financial services industry.

John Campbell, deputy chair of FiSAB and chairman of FSE, says: "We believe this is the first time a country has held such an event and it is indicative of the innovation and dynamic approach that the Scottish financial services industry has always taken."

Despite the setbacks of the credit crunch and the downturn in the economy, the development of the financial services industry in Scotland has continued apace, with the International Financial Services District in Glasgow attracting many back office operations.

Figures show Glasgow has seen a 34 per cent increase in the number of people working in the financial services industry since 1995, with more than 13,000 created in the IFSD.

Other locations, such as Dundee and the Gyle in Edinburgh have also seen continued growth in the number of financial services institutions based there.

One of the more high-profile moves over the last 12 months has been the decision by banking giant HSBC to open a dedicated Scottish private banking office in Scotland last January.

Joss Mitchell, director for Scotland, who heads up the Scottish team, says there were two main reasons for opening the office.

"First, it is a response to demand from clients who are currently being serviced from London," he explains.

"Many operate in a global environment, but want the added convenience of being able to transact their affairs from closer to home.

"Second, Scotland is home to a growing number of successful individuals who want to choose a personalised yet international banking service and we believe we can deliver that."

At this time last year, the Scottish financial services companies were bracing themselves for the introduction of the EU's Markets in Financial Instruments Directive (Mifid), which came into force last November.

But, while there was much wailing and gnashing of teeth, it appears to have been a damp squib in terms of having a detrimental effect north of the border.

Claxton recognises that Mifid was something that had to be done and affected companies that have had to adopt to the change in rules. But he warns that a bigger change will be the rules on treating customers fairly that the Financial Services Authority (FSA) expects all firms to have implemented by the end of this year.

"That will be a cultural change to the industry and, given the retail base in Scotland, that will have a more marked effect than Mifid," explains Claxton.

Financial services in Scotland

Accounts for over £7bn (over 7%) of Scotland's GDP

Is fastest growing sector of the Scottish economy (up 55% in 7 years; UK up 44% in the same period)

Accounts for 10% of the Scottish workforce

UK headquarters to four clearing banks and four major insurance companies